Towards a free trade nation (2)

Towards a free trade nation (2)

This the second of two articles based on an excerpt from a
paper by Ali Wardhana presented at the seminar of Indonesia and
the World at the Beginning of the 21st Century jointly organized
by The Jakarta Post and the Center for Strategic and
International Studies on Oct. 17 in Jakarta in connection with
the 50th anniversary of Indonesia's independence.

JAKARTA (JP): The government must do more than join and shape
international agreements if we are to take full advantage of the
global economy. I stated earlier that comparative advantage is
not a static concept. As our abundant labor and natural resources
are absorbed into industry and modern services, we will find that
the cost of these resources climbs as our incomes rise. We will
have to move on to more skill-intensive and more technology-
intensive industries. The role of government in preparing for
this transition is one of the burning policy questions that we
face.

There are those who would have us "pick winners". This is the
strategy attributed to Korea and Japan. In fact, the importance
of picking winners in Korea and Japan is hotly debated by
development specialists. There is no consensus on the extent to
which these policies contributed to the rapid growth of those
countries. But in a number of ways the debate is a moot one. The
globalization of the world's economy and the emergence of widely
agreed-to-rules on acceptable practices toward trade and
investment mean that the policies attributed to Korea and Japan
can no longer be followed.

The industrial policies of those countries revolved around a
set of controls that enabled a government to allocate credit and
foreign exchange to firms in the chosen sectors which conformed
to the government's will. Further, those firms were protected at
home from competition from imports and from local production by
foreign investors. Unlike most inward-looking Latin American
countries, however, the governments of Korea and Japan demanded
efficiency of the favored firms. They had to face the rigors of
export competition, or they did not receive credit or foreign
exchange, or, in some cases, even further protection from foreign
competition. The tools required to implement such a policy are
complex. More important, they are no longer tolerated in today's
integrated world.

Our commitment today must be to the private sector, with a
role for government only where the private sector cannot be
expected to undertake tasks. There are two tasks that the
government must perform to ease the transition to the industries
of the future: the provision of broader and better education and
easing the way for private firms to develop technology and to
acquire it from abroad.

The most significant obstacle to technology transfer is the
capacity of developing economies to absorb and adapt technology.
This capacity depends primarily on the human resource capacity of
each economy. In recognition of the importance of science and
technology to our development, Indonesia has made human resource
development a top priority during our second 25 year development
program. This priority manifests itself both in our commitment to
nationwide junior secondary education and in our commitment to
increase the quantity and quality of tertiary graduates. This
includes greatly increasing the number of natural science and
engineering students in higher education.

One of the key lessons to be learned from other countries'
experiences is that technology development must be market-
oriented and serve the needs of the private sector. Research
conducted within government institutions and state enterprises
can be divorced from the needs of modern business and industry.

This is a particular problem for Indonesia, where roughly 80
percent of research and development is both funded and performed
by the government or in state-owned industries, and over 75
percent of natural scientists and engineers are employed by the
government. The most urgent step currently needed is to increase
the efficiency of technology diffusion by getting research and
development out of government labs and state enterprises and into
the private sector, where it would be directly relevant to
industry. To support this process, the government is encouraging
private firms to devote greater resources to research and
development.

As we strive to raise the level of technology in Indonesian
industry, we must be careful not to adopt policies that weaken
our existing industries. In this regard I agree with Professor
Sumitro's observation on the need to find the correct balance
between "comparative" advantage and "competitive" advantage,
while at the same time preparing ourselves for the future when we
must move up the technology ladder.

We cannot prematurely reject natural resource-intensive and
labor-intensive industries as we lay the groundwork for the skill
and capital-intensive industries of the future. We must continue
to support these industries for two reasons. First, they are a
vital source of foreign exchange, accounting for almost one-half
of non-oil exports, but on the other hand contributing very
little to our net foreign exchange earnings and unlikely to do so
for some time to come.

In light of the recent increase in our current account
deficit, it would be unwise to abandon the industries that have
become a mainstay of our economy over the past decade. Second,
high-technology industries employ primarily skilled workers, such
as technicians, engineers and natural scientists. However, two-
thirds of Indonesia's labor force has no more than a primary
school education. If we push aside labor-intensive industries to
devote resources to high-tech industries, where will these 60
million-odd workers find jobs? Let us continue to support
industries in which we are currently competitive, while investing
in human resource development that holds the promise for
Indonesia's future.

The dilemmas of managing the domestic economy in a world where
borders are open to the easy flow of goods and money have long
been clear from economic theory. The theory said that with highly
mobile international capital, if we chose to maintain stability
in the exchange rate, then our ability to use macro economic
policies to stabilize the economy would be limited. On the other
hand, if we insist on ease in managing the domestic economy, then
we would have to accept greater instability in the exchange rate.
Managing stability in both simultaneously would be extremely
difficult.

In practice, until recently the constraints were more a
theoretical matter than a real dilemma. When the economy became
overheated in 1991, for example, we were able to apply monetary
brakes without a serious challenge to the exchange rate policy.
As many of you will remember, rather straightforward and simple
policies that raised interest rates were effective in slowing the
economy.

The world has, however, changed very rapidly. Global capital
movements are now somewhere in the order of 70 times the value of
world trade in goods. This integration of world capital markets
has caused the theoretical problem to become a real problem.
Today, if we raise interest rates significantly above
international rates plus some risk premium, we are likely to face
massive inflows of capital. These incoming funds would push the
exchange rate up, requiring the central bank to purchase foreign
exchange with rupiah and thereby increase money supply. But these
increases in money supply would run counter to the original goal
of slowing down the economy.

Some academics would say that there is a simple solution to
the problem. Ignore the exchange rate: just let it seek its own
level and concentrate on the domestic economy. In the short run
exports would be hurt by the higher valued rupiah, but eventually
the exchange rate would return to a rate that allows exports. Or
domestic prices would be held in check until exports were once
again competitive. This is, of course, a purely academic
solution.

There are those who would say that a country could resolve
this dilemma by imposing controls on the flows of capital, that
in this way a country could have stability in its exchange rates
as well as control over the domestic economy by limiting the
cross-border flows of capital. This sounds deceptively simple.

Before I address those who would support capital controls, let
me say that Indonesia has followed a policy of open capital
account for some 25 years, and we have no intention of abandoning
policies that allow investors to repatriate their profits and
capital without restriction. This policy has served us well, and
will continue to do so.

Are we then on the horns of a dilemma, with no effective
policy tools? I am convinced that the answer is no. But I do
believe that we need to draw on a more complex set of management
tools and may even need to somewhat revise the incentives under
which some of our institutions operate.

First, the inflows of foreign capital that accompany higher
interest rates need not increase the money supply and thus
generate impacts opposite to those intended. Thus far, there is
no evidence that the inflows accompanying tightened monetary
policy are greater than those that can be sterilized by the
conventional tools of selling Bank Indonesia's deposit
certificates and issuing less money market securities. Bank
Indonesia has generally been very effective in these policies,
even create difficulties for sterilization efforts.

Second, we have not exhausted other tools for managing the
economy. We have more options than simply driving up interest
rates through the sale of Bank Indonesia's deposit certificates
or the manipulation of money market securities. We have, for
example, not varied the reserve requirements of our bank, as
other countries do. Radical changes could certainly threaten the
solvency of some banks, but small changes may act as an effective
tool for managing the domestic economy.

Third, fiscal policy remains an effective tool for managing
the economy. Slowdowns in government spending, for example, or
acceleration of tax collection serve to slow the economy. If
inflation and current account imbalances become a serious
concern, Indonesia could strive for an overall fiscal surplus
along the lines achieved by other fast-growing, low inflation
economies as Thailand and Malaysia. Some neighboring countries
have also relied quite heavily on a variant of fiscal policy as
they have timed releases from their "provident" funds to counter
business cycles.

Fourth, Indonesia can support the efforts of international
agencies such as the World Bank and the International Monetary
Fund to seek new institutional means for responding to crises
that disrupt world financial markets. The Mexican crisis of less
than a year ago drew the world's attention to the serious
disturbances that can result from the integration of capital
markets and the ease with which money now flows across
international borders. Large capital inflows can mask imbalances
caused by poor macroeconomic management, and capital -- including
domestic capital -- can bail out in a hurry when the imbalances
become unsustainable.

Moreover, if investor confidence in one market is shaken, the
ensuing ripple can threaten perfectly sound economies.

Dr. Ali Wardhana is a former economics minister and is one of
the leading architects of the New Order economy.

Window A: As we strive to raise the level of technology in
Indonesian industry, we must be careful not to adopt policies
that weaken our existing industries.

Window B: We need to draw on a more complex set of management
tools and may even need to somewhat revise the incentives under
which some of our institutions operate.